... a different (different from Stephen Roach) view from Morgan Stanley ...
July 09, 2002
United States: From Vicious to Virtuous?
Richard Berner and David Greenlaw (New York)
How will the tension between a recovering economy and sliding financial markets, especially equities, be resolved? That's critical for the outlook, because a further significant deterioration in capital market prices could menace the budding reacceleration in final demand that has emerged in recent weeks. Call us optimists: We think the revival in the economy will begin to lift equity and debt markets from their funk. A better-than-expected recovery and high operating leverage should generate solid gains in corporate profits -- profits after taxes, interest and depreciation. For a market fearful of a too-tepid recovery or even the dreaded double dip, that should come as good news. But the recovery in markets may be prolonged and atypically lag behind the economic recovery, if further corporate shocks elevate risk premiums beyond current levels.
In our view, fears that financial conditions have turned restrictive are overblown. Markets would have to move significantly further to create new financial headwinds for an economy that has fought them for the past two and a half years. To be sure, sagging stock prices are only one dimension of financial restraint. In addition, concerns that the impact of WorldCom's alleged fraud will create a broad-based credit crunch have also risen sharply in the past two weeks as corporate spreads have widened.
But four factors likely will mute the potential financial restraint from sagging stock prices and credit woes. First, stock prices have been sliding irregularly for 28 months, yet the economy has begun to recover, courtesy of policy stimulus, lower market interest rates, and cyclical forces (such as inventories turning from top-heavy to lean). Second, a gradual recovery in stock prices would significantly mute the negative fallout from negative wealth effects (see "Duration Matters," Global Economic Forum, July 4, 2002).
In addition, in our judgment, the fallout from WorldCom is unlikely to result in a broad credit crunch. We define a credit crunch -- which would be prima facie evidence of systemic risk -- as the inability of even good companies to borrow. While secondary trading of some corporate issues has become more difficult and corporate spreads have widened slightly since the WorldCom bombshell, Steve Zamsky and we see scant evidence that Corporate America is having more difficulty raising funds. Indeed, Steve notes that most sectors in the corporate market are trading broadly midway between their post-9/11 spread tights and wides. The exceptions are obviously telecom and utilities (especially distressed generators/power merchants). In sharp contrast, bank spreads are still narrower than they were last September, and roughly half of what they were in January 2001. So while the recent price action in bank stocks points to some earnings risk, the action in bank debt spreads sends a strong signal that neither solvency risk nor a credit crunch is likely.
Finally, lower market interest rates, a weaker dollar, and ample liquidity should continue to be significant offsets. We see ten-year Treasuries in a 4 1/2% to 5 1/4% range for now, reflecting those concerns (see "Flight to Quality: A New Range for Treasuries," Global Economic Forum, June 20, 2002). And the Fed is likely to delay moving monetary policy away from a highly accommodative stance until late this year, to assure that that sector-specific credit problems don't spread (see "WorldCom's Macro Implications," Global Economic Forum, June 28 2002). Thus, unlike Steve Roach, we do not think that systemic risk will create new financial headwinds for the recovery (se his "The Drumbeat of Systemic Risk," Global Economic Forum, July 8, 2002).
Fine, but what about the pace of recovery? We said when the pause in growth began in March that we'd know in three or four months whether or not the pause was temporary or a more lasting downshift. In particular, we expected a faster pace of job, income, and profits growth to be three critical drivers of a sustainable acceleration. Yet job gains so far have disappointed. Nonfarm payrolls rose a meager 36,000 in June, and for the fourth month in a row, what looked like the beginnings of job improvement in the two prior months was revised down by a net of 44,000. That's hardly the stuff of a vigorous recovery, let alone the typical postwar rebound, and it calls into question the economy's capacity to generate the income that will fuel accelerated consumer spending.
Despite the jobless recovery, however, income and profits are rebounding right on schedule. Real wage gains and tax cuts are sustaining consumer wherewithal; despite June's tepid job gains, weekly earnings jumped by 0.7%, turning what had been flat real pretax wage income into a 1.2% annualized gain in the first half of 2002. In turn, the ongoing impact of tax cuts turned that slender rise into a hearty 4.2% after-tax gain. Meanwhile, production gains and operating leverage -- the keys to earnings growth -- are producing an on-time earnings recovery. The perception is that, lacking pricing power and vigorous nominal top-line growth, little will drop to the bottom line. The reality, in our view, is that a weaker dollar is already restoring purchasing power in many industrial business lines, and expanding margins are translating moderate revenue growth into strong earnings gains. As a result, second-quarter earnings are likely to show positive comparisons for the first time in five quarters.
In response to those gains in income and profits, consumer and capital spending are accelerating. After a flat second quarter, vehicle sales are rebounding, and should get a further assist from new financing deals. A return to normal weather and improved income gains are helping seasonal spending to revive from its spring torpor. And contrary to popular perceptions, the American consumer is stepping up spending and rebuilding saving concurrently (see "Testing Time for the US Consumer," Global Economic Forum, June 17, 2002).
For their part, companies seem to be talking cautiously about both hiring and capital spending but acting more confidently about the latter. The five factors that we've long felt will trigger a capital spending recovery -- the end of the capex overhang away from telecom, an economic acceleration, rebounding profits, a lower cost of capital, and new tax subsidies for investment -- all seem to be falling into place. Based on data through May, real nondefense capital goods orders excluding aircraft jumped at a 14.7% annual rate in the second quarter, and anecdotal evidence hints at further gains. Consequently, once again we are revising up our forecast for capital spending. Frankly, the risks, if anything, point to further gains. The upshot: We believe this acceleration, fueled by improving consumer and capital spending, is morphing into a hearty recovery.
Little of this has yet to impress market participants. Understandably, they are now wary of numbers, whether they come from Main Street, Wall Street, or Washington's statistics mills. A recovery without healthy job gains has no "feel-good" factor. And no one is prepared to catch the falling knife of stock prices. What is fascinating is that momentum is now working to the downside. The same observers who couldn't get enough tech stocks when prices were soaring in 1999 and early 2000 now believe that tech won't recover for years and that the market must overshoot below historic norms in order to have some semblance of value. We're still nervous that disgust with corporate malfeasance and risk aversion are eroding the American equity culture. But as Steve Galbraith points out, fully one-third of all companies in the S&P 500 trade at less than 17 times this year's earnings and are forecast to post double-digit earnings growth in the year ahead. And unlike the situation in corporate bond land, where high-quality names are not especially cheap, investors have indiscriminately thrown some high-quality babies out with the bath water. Consequently, we believe that disciplined investors who pay attention to value will eventually put a floor under stock prices.
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